Playing Small Tech

If, like me, you are old enough to have vivid memories of the tech wreck that saw the Nasdaq drop from a peak of more than 4,800 in March 2000 to below 800 in October 2002, then you probably have a nasty sense of déjà vu when you look at the valuations given to some tech companies right now.

The bursting of the dot-com bubble looks so obvious with hindsight that it is hard to remember the optimism and enthusiasm that led up to it. We all knew that e-commerce was the future and, as it turned out, we were right. We just got a bit ahead of ourselves and lost sight of the fact that popularity and potential are great, but it is the other "P" -- profitability -- that counts.

It would seem that, in the areas of social media and marketing to mobile devices, we are in a similar place at the moment. It's not that these industries don't have a great future. It's just that valuations are starting to look a little frothy.

Twitter (TWTR) could well be the next Google (GOOG) for investors, but, seriously, $40 billion for a company that has yet to turn a profit? Add to that last week's news that Snapchat, which has never even produced any revenue, turned down an offer of $3 billion from Facebook (FB) and the parallels become clearer.

As I said, I've seen this movie before.

Understanding that there is a bubble is one thing, but profiting from that understanding is another. The aforementioned TWTR may look overvalued at the moment, but it has enormous reach and a plan to monetize its popularity. The problem is potentially more acute in the Snapchats of this world, companies that are garnering sky-high valuations despite never even producing any revenue, let alone profits.

The problem that traders and investors face is that Snapchat and others like it are not yet traded companies. So, how best to position yourself for what looks like an inevitable correction? In fact, even if you believe that the exponential growth in valuations can continue for a while and want to ride the wave, you face the same problem.

The answer could lie in the somewhat obscure area of business development companies, or BDCs. BDCs are pass-through entities, somewhat like REITs and MLPs, that make their money by loaning money to young and start-up businesses. They make what are effectively subprime loans to businesses and get paid decent interest, leading to high yields for investors with an appetite for risk.

Herculese Technology Growth Capital (HTGC) is a BDC that invests in small tech companies. It isn't a pure play on the bubbly area as it is also involved with biotech startups. But, as you can see from the chart, they have had a good year and it is reasonable to assume that if there is a bubble and it pops, they will be hit hard.

If you are of the opinion that everything is fine and small-tech companies are still a great opportunity, then buying HTGC is way to have a stake in non-public companies in the sector. If you are like me and sense a bubble, it is not as simple as shorting the stock. That yield I mentioned, which is currently around 7.7%, makes shorting HTCG very expensive. Options may provide a better chance for sellers, but you should be aware that there are limited strikes available and not much liquidity. Still, you could pick up April 2014 17.50 puts for around $1.50 that would show a nice return if my fears are accurate.

I am not by nature a pessimist and would love to see all of these innovative entrepreneurs succeed. But my background in trading rooms has taught me that if you sense irrational exuberance, it is sensible to insure yourself against a sharp unwinding.